MANAGEMENT SCIENCE Vol

MANAGEMENT SCIENCE Vol. 59, No. 7, July 2013, pp. 1479–1495 ISSN 0025-1909 (print) ISSN 1526-5501 (online) http://dx.doi.org/10.1287/mnsc.1120.1657 © 2013 INFORMS The Loser’s Curse: Decision Making and Market Efficiency in the National Football League Draft Cade Massey The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104, [email protected] Richard H. Thaler Booth School of Business, University of Chicago, Chicago, Illinois 60637, [email protected] question of increasing interest to researchers in a variety of fields is whether the biases found in judgment Aand decision-making research remain present in contexts in which experienced participants face strong economic incentives. To investigate this question, we analyze the decision making of National Football League teams during their annual player draft. This is a domain in which monetary stakes are exceedingly high and the opportunities for learning are rich. It is also a domain in which multiple psychological factors suggest that teams may overvalue the chance to pick early in the draft. Using archival data on draft-day trades, player performance, and compensation, we compare the market value of draft picks with the surplus value to teams provided by the drafted players. We find that top draft picks are significantly overvalued in a manner that is inconsistent with rational expectations and efficient markets, and consistent with psychological research. Key words: overconfidence; judgment under uncertainty; efficient market hypothesis; organizational studies; decision making History: Received August 9, 2011; accepted August 31, 2012, by Uri Gneezy, behavioral economics. Published online in Articles in Advance March 18, 2013. 1. Introduction economic analysis is that teams often trade picks. For Two of the building blocks of modern neoclassical example, a team might give up the 4th pick and get economics are rational expectations and market effi- the 12th pick and the 31st pick in return. In aggregate, ciency. Agents are assumed to make unbiased pre- such trades reveal the market value of draft picks. dictions about the future, and markets are assumed Although it is not immediately obvious what the rate to aggregate individual expectations into unbiased of exchange should be for such picks, a consensus has estimates of fundamental value. Tests of either of emerged over time that is highly regular. One reason these concepts are often hindered by the lack of for this regularity is that a price list—known in the data. Although there are countless laboratory demon- league circles as “the Chart”—has emerged and teams strations of biased judgment and decision making now routinely refer to the Chart when bargaining for (for recent compendiums, see Gilovich et al. 2002, picks. What our analysis shows is that although this Kahneman and Tversky 2000), there are far fewer chart is widely used, it has the “wrong” prices. That studies of predictions by market participants with is, the prices on the chart do not correspond to the substantial amounts of money at stake (for a recent correct relative value of the players. We are able to review, see DellaVigna 2009). Similarly, tests of finan- say this because player performance is observable. cial market efficiency are often plagued by the inabil- To determine whether the market values of picks ity to measure fundamental value. are “correct,” we compare them to the surplus value In this paper we investigate how rational expecta- (to the team) of the players chosen with the draft tions and market efficiency play out in an unusual but picks. We define surplus value as the player’s perfor- interesting labor market: the National Football League mance value—estimated from the labor market for NFL (NFL), specifically, its annual draft of young players. veterans—less his compensation. In the example just Every year the NFL holds a draft in which teams mentioned, if the market for draft picks is rational, take turns selecting players. A team that uses an early then the surplus value of the player taken with the 4th draft pick to select a player is implicitly forecasting pick should equal (on average) the combined surplus that this player will do well. Of special interest to an value of the players taken with picks 12 and 31. Thus, 1479 Massey and Thaler: Decision Making and Market Efficiency in the NFL Draft 1480 Management Science 59(7), pp. 1479–1495, © 2013 INFORMS our null hypothesis is that the ratio of pick values will comparing the benefit of using a pick to the opportu- be equal to the ratio of surplus values. nity cost of foregone trades. We then perform a more The alternative hypothesis we investigate is detailed cost-benefit analysis of each player selected that a combination of well-documented behavioral in the draft, by calculating the surplus value that the phenomena, all working in the same direction, cre- player provides to the team, namely, the performance ates a systematic bias causing teams to overvalue value (estimated by the price of an equivalent veteran the highest picks in the draft. For example, this is player) minus the salary paid. These analyses allows the result we would expect if teams overestimate us to test for and reject market efficiency. their ability to determine the quality of young players. Market forces will not necessarily eliminate this mispricing because even if there are a few smart 2. Background Information teams, they cannot correct the mispricing of draft Although it is not necessary to know the difference picks through arbitrage. There is no way to sell the between an outside linebacker and a cheerleader to early picks short, and successful franchises typically follow the analysis in this paper, it is important to do not “earn” the rights to the very highest picks, and have some background regarding the nature of this so cannot offer to trade them away. labor market. There are three essential features. First, Our findings strongly reject the hypothesis of mar- new players to the league are allocated to teams via ket efficiency. Although the market prices of picks an annual draft. Teams take turns selecting players in decline sharply initially (the Chart prices the first pick an order determined by the previous year’s record. at three times the 16th pick), we find surplus value There are seven rounds of the draft, and in each of the picks during the first round actually increases round the worst team chooses first and the champion throughout most of the round: the player selected chooses last (with some minor exceptions). The play- with the final pick in the first round, on average, pro- ers selected are then signed to a contract, historically duces more surplus to his team than the first pick! four to six years. Players can only sign with the team The market seems to have converged on an inefficient that selected them. equilibrium. As we discuss in §4, both the Chart and Second, the league has adopted a rule setting a a robust rule of thumb regarding the trading of a pick maximum amount any team can pay its players in this year for a pick next year have emerged as norms a given year. This is called the salary cap. The cap in the league, norms that appear to be difficult to dis- has increased over time, from $34.6 million in 1994 lodge even though the values these norms imply are to $128 million in 2009. When players are signed to demonstrably wrong. multiple-year contracts, there is usually a guaranteed The setting for this study is unusual, but we sug- up-front bonus payment plus annual salaries. The gest that the implications are quite general. It is accounting for the salary cap rule allows the teams known in financial economics that limits to arbi- to allocate the bonus equally across the years of the trage can allow prices to diverge from intrinsic value, contract. Whenever we report player compensation but some version of market efficiency remains the in this paper we are using the official cap charge as 1 working hypotheses (sometimes implicitly) even in reported to the league. The existence of this salary markets where there are no arbitrage opportunities. cap makes it easier to draw robust conclusions about Are competition and high stakes enough to produce market efficiency because all owners face the same efficiency? We show that they are not. We study a upper limit on what they can spend, unlike in pro- domain in which it is arguably easier to predict per- fessional baseball or European soccer. In those sports, formance than, say, the market for most employees, rich owners can buy the rights to star players to suit even CEOs. Teams have been able to watch prospects their own preferences, and it would be impossible for several years play the same game they will play in to say they are paying “too much” without knowing the pros, and also have administered days of physical their utility function. In the NFL, hiring a star to a big and mental tests. Still, we find their ability to predict salary limits what can be offered to other players, so performance incommensurate with their confidence. owners are forced to choose which players they wish Similar judgments about the future undergird many to spend their budget on. important decisions. Whether deciding to hire a CEO, Third, there is also a special “rookie salary cap” invest in a new technology, or to use military force, that limits the amount of money a team can spend on it is critical that one’s confidence level is appropriate. first-year players, both drafted and undrafted (most For the initial step in our analysis, we use a data set teams typically sign several of these each year).

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